Tapering, Treasury Rates, and a Series of Steps

On December 18, 2013 the Federal Open Market Committee (FOMC) announced they’d taper their massive bond-buying program by US$10 billion per month beginning in January 2014. While market participants and analysts had long obsessed over if and when taper would begin, market interest rates had already begun adjusting to the quickly approaching reality of reduced purchases. But have market interest rates substantially adjusted to a new fundamentally driven equilibrium, or will reduced purchases drive interest rates even higher from here?

From September 2011 through April 2013, long-term interest rates were held down by market confidence in the FOMC’s promise to hold the fed funds rate close to zero indefinitely and an open-ended long-term asset-purchase program. Back in May 2013, Fed Chairman Ben Bernanke brought up the idea that long-term asset purchases may not persist forever, which led ten-year U.S. Treasury rates to rise by 130 basis points (1.3%) over a four-month period. This selloff occurred prior to the FOMC actually announcing the taper action, and that’s made some question how far long-term interest rates may increase once the taper program actually begins.

With core inflation under 2.0%, unemployment at 7.0%, economic growth in the 2.5% range, and fed funds close to 0%, I believe fundamental fair value for ten-year U.S. Treasury rates is close to 2.75%, but will rise to 3.0% by midyear. So yes, I believe long-term rates have substantially adjusted to the taper and will rise or fall more directly with economic data during the course of 2014. However, with the largest buyer of securities over the past two years (i.e., the Fed) now reducing their purchases most likely every month or so throughout 2014, long-term interest rates may remain above fair value since new buyers need to be enticed back in to the market. Ten-year Treasurys are trading about 25 basis points (0.25%) higher than fair value, so if today’s market is any guide, these rates may move up towards 3.25% by midyear. Of course, as the economy climbs higher, it will inevitably sway to and fro, causing some volatility in the long-term rate levels.

One last thought concerns short-term rates such as two-year U.S. Treasury rates, which are yet being held down by the FOMC’s promise to remain on-hold indefinitely. While I do expect some upward movement in two-year U.S. Treasury rates this year, the much bigger move will come later through a series of steps culminating with the Fed raising the fed funds rate. Before the Fed actually raises the fed funds rate, they’ll need to adjust their statement language so as to not promise to be on-hold any longer, and before they adjust their language they’ll most likely allude to the potential need for adjustment. Before the allusion, they’ll need to see better economic data with inflation rising above 2.0% and, importantly, the unemployment rate sustainably falling below 6.5%. I believe this process will begin early in 2015, with the Fed likely to raise rates in late 2015. Stay tuned, because 2015 could bring substantial volatility to short-term Treasury rates.

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